Merkel Cautions Central Bankers

German Chancellor Angela Merkel caused a stir when warning the European Central
Bank not to engage in asset purchases. She has received a lot of attention
as it is an unwritten rule not to infringe upon the independence of central
bankers. While we would typically agree that the independence of central bankers
is of paramount importance, we believe it is not only appropriate, but also
her duty to speak out. Let us elaborate.

As a backdrop, it is the primary role of central banks to ensure price stability.
To achieve price stability, central banks traditionally control money supply
or the cost of credit available to the banking system. This is referred to
as monetary policy. Part of the role of central banks is to "take away the
punch bowl" when the party is getting out of hand. Central banks are given
independence so that they can take the tough measures necessary, possibly to
induce a recession, to focus on their mandate to promote price stability. In
the U.S., the Federal Reserve (Fed) has a dual mandate, namely to also pursue
a policy promoting maximum sustainable growth; in Europe, the ECB has a "single
needle" as ECB President Trichet likes to call it, to pursue price stability.

When Merkel speaks out, there are two dimensions to consider, one fiscal and
one monetary. On the former, central banks throughout the world have veered
into fiscal policy by engaging in specific asset purchase programs. That's
outside of the mandate of central banks and Merkel is doing the only right
thing by warning that such policy must be reversed. The ECB recently announced
it may start buying "covered bonds", mortgage backed securities popular in
Germany. The purchase of covered bonds ought to be a fiscal, not a monetary
decision, as a specific sector of the economy is supported. The reason for
central banks to engage in these types of programs is that such "credit easing" as
Fed Chairman Bernanke likes to call it, is a targeted stimulus, possibly less
costly than trying to provide liquidity to the banking system as a whole. However,
we have questioned the value of such programs as they tend to substitute, not
encourage, private sector activity as prices are driven to levels where rational
players may want to abstain.

More importantly, asset purchase programs are also highly problematic as they
are extremely difficult, if not impossible, to unwind. Securities purchased
tend to have maturities measured in years, not days. In practice, we do not
see how it is possible to ever resell such securities in the market. There
are numerous ways that have been proposed to "sterilize" such purchases, but
- in our view - all proposals have fundamental flaws. That means, central banks
engaged in asset purchases, the Fed in particular, may dig themselves into
a corner, unable to mop up liquidity when economic growth resumes. Substantial
inflation may be the result.

Just as importantly, when central banks veer into fiscal policy, they invite
political backlash. Watch this unfold in the U.S. - Wednesday's testimony by
Fed Chairman Bernanke in the House Budget Committee was already far more acrimonious
than in the past. It comes with the nature of meddling with fiscal territory
- the Fed ought to find a way out from such policies, fast. The ECB should
not veer into such territory.

The other is a monetary issue - is too much money being printed? This is open
to argument; however, as far as Germany's economy is concerned, it can stomach
a recession far better than Anglo-Saxon economies, as Germany's economy has
less leverage. It is therefore absolutely in Germany's interest to err on the
side of caution. Again, the primary role of a central bank is not to support
growth, but to ensure price stability. It is more than appropriate for a politician
to speak out when central bankers are at risk of veering from their mandate.

The ECB's policy makers will not be rocked by the comment of the Chancellor,
although I very much hope the ECB listens. And it is not so much about the
fight between the offices, but in the ECB's interest to stay on track to pursue
sound monetary policy. Some say Merkel's comments may drive a transatlantic
wedge into policies just when greater coordination is needed. That gives Merkel
too much credit - that process started about 6 years ago and is breaking into
the open now. The ECB has long showed more restraint; Trichet and his predecessor
Wim Duisenberg have long made it clear that they prefer suboptimal growth and
possibly a recession over the expansionary policies pursued by the Fed. Giving
Merkel credit for the divergence does not give credit to the ECB.

Axel Merk, President & CIO of Merk Investments, LLC, is an expert on hard
money, macro trends and international investing. He is considered an authority
on currencies.

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